Day Nine: Ten of the Biggest Mistakes in Option Trading
Option Sellers Beware
In day seven Mark Wolfinger penned a warning for option buyers. I thought it appropriate to provide the yang to Mark’s ying.
I don’t recall where I read that options sellers eat like chickens and shit like elephants, but I sure laughed hard and the phrase still brings a smile to my dial. I’m predominately an option seller and can testify to having been covered by a few large steaming piles in my time.
Experienced traders will extol the virtues of buying protection for written options. That is insuring you’re not naked. Unfortunately those new to the trading options seldom listen to that advice for a number of reasons.
- Buying protection reduces the attractiveness of a position.
- Buying protection forces an acknowledgement and assessment of the risk and requires more involved calculations.
- It won’t happen to me.
- I’m happy to buy or sell at that strike price.
- I’ll close the position if it moves against me.
Two words sum up the danger, surprise volatility. In Bleed or Blowup, Nasim Taleb has the following to say
In some strategies and life situations, it is said, one gambles dollars to win a succession of pennies. In others one risks a succession of pennies to win dollars. While one would think that the second category would be more appealing to investors and economic agents, we have an overwhelming evidence of the popularity of the first. A popular illustration of such asymmetry in returns is evident in the story of the Long Term Capital Management hedge fund. The fund derived steady returns over a dozen quarters then lost all of them in addition to almost all its capital in a single observation (see Lowenstein, 2000) –only for the main principals to restart a new, albeit milder, version of the strategy. Is there a systematic bias in favor of such return profiles?
That’s right LTCM were options sellers. So if the most intelligent (note I didn’t say smartest) collection of people to ever form a hedge fund blew up selling options, why do newbie option traders think they can better?
How to Overcome the Dangers of Selling Options
Slip, slop, slap. Slip on some protection, slop on some protection, slap on some protection. Buy a lower priced put or higher priced call to protect yourself from surprise volatility.
Invert your thinking. In day five, believing writing covered calls is conservative, I highlighted how covered calls are not as risk free as many investors think. The easiest way to overcome the danger of writing covered calls is to invert your thinking by considering whether you would write a put on the stock at the same strike price. As a put is equivalent a covered call that simple mental gymnastics helps me decide whether I should be writing the covered call or simply selling the stock.
While that takes care of downside risk, which to me is the real risk, many experienced investors have argue that missing out on the upside is an even greater risk. While I disagree, I certainly concede that forfeiting upside is a risk that many investors ignore. Is it worth selling that $50 call for $1 when the at expiration the share could be $60?
When you sell options you are in general forfeiting upside while taking on the downside risk. You’re behaving like an insurance company and as such it pays to re-insure against catastrophic risk.
More:
- Day Eight in this series of options trading mistakes.
- The series so far, ten biggest mistakes in option trading.
Related posts:
- Day Five: Ten of the Biggest Mistakes in Option Trading
- Day Seven: Ten of the Biggest Mistakes in Option Trading
- Day Six Part 2: Ten of the Biggest Mistakes in Option Trading
- Day Two: Ten of the Biggest Mistakes in Option Trading
- Day Eight: Ten of the Biggest Mistakes in Option Trading
- Day Four: Ten of the Biggest Mistakes in Option Trading
What about the strategy of selling front month slightly OTM calls (covered) during options expiration week? Yes the premiums are usually pitiable since the contracts are only days away from expiring, but you can squeeze out a little money and you’re only locked into the underlying for 5 days (or less). You always have options buyers chasing lottery tickets, even more so during expiraiton week, so why not take a bite here?
And speaking of which, from an options buying (lottery ticket) perspective during options expiration week, what about gambling on volatile events that are scheduled to occur for several companies on the week of expiration? For example, many companies have earnings that come out the same week as options expiration, and in the event that there’s a shocking earnings disappointment or surprise on top of the fact that expiration for contracts is days away, options buyers could find themselves with a major homerun should the underlying experience a huge move that same week. Since the options premiums have lost their time value and are days away from being worthless, it is possible in these particular circumstances for “just slightly” OTM calls/puts to go from cents to dollars in a day thanks to their looming expiration and the volatile event that caused the underlying to explode.
Thoughts?
Hi Strike Out, good questions. What follows are my thoughts and no doubt others have differing opinions. First though let me say there is no right or wrong strategy in options, there are simply appropriate strategies that fit your personality and the outcomes you’re seeking.
Selling lottery tickets You almost covered the downside of this strategy with the second part of your question. If you keep selling options for a pittance one day surprise volatility will take away all (more or less) of your gains in one swoop. A classic Black Swan. Surprise volatility is one of more interesting strategies for call buyers. If you can stomach lots of small losses then buying those calls on the probability that one day you’ll get a big pay off is an interesting strategy. If you like lots of small gains and don’t mind a a big loss/missing a big gain then scalping those nickels may be for you.
That takes me to Buying lottery tickets. I’ve found the option market to be more efficient than the share market. If there is expected volatility that will be priced into the options. e.g. earning call or FDA announcement. If you can stomach lots of small losses then that may be a worthwhile strategy. As most people are wired to take lots of small gains and to forget the occasional big loss then it is probable that strategy will be more profitable over the long run than scalping those nickels in the last week. The issue is can you really stomach all those small losses month after month after month. I couldn’t.
If you think you can then I’d love to know how it works out and what you discover.
An tangential strategy may be buying calls on biotech stocks over the coming years. With many pharma companies needing to fill pipelines I consider it likely there will be heightened M&A is the sector this year.
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